Thursday, October 29, 2015

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends.

Some of these trends have challenged the traditional view of academic economists and policy makers about how an economy works. Some of the facts that very few would have anticipated:
- The idea that central banks cannot lift inflation rates closer to their targets over such a long horizon.
- The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output.
- The slow (or inexistent) natural tendency of the economy to adjust by itself to a new equilibrium.

To be fair, some of these facts are not a complete surprise and correspond well with the description of depressed economies that have hit the zero lower bound level of interest rates because of deflation or "lowflation". We had been warned about this by those who had studied the Japanese experience: both Krugman and Bernanke, among others, had described these dynamics for the case of Japan. But my guess is that even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies. Most thought that this was just a unique example of incompetence among Japanese policy makers.

Now we have learned that either all central bankers are as incompetent as the Bank of Japan in the 90s or that the phenomenon is a lot more natural, and likely to be repeated, in economies with low inflation, more so when the natural real interest rates is very low.

But if this scenario is more likely to happen going forward it might be time to rethink our economic policy framework. Some obvious proposals include raising the inflation target and considering "helicopter money" as a tool for central banks. But neither of these proposals is getting a lot of traction

My own sense is that the view among academics and policy makers is not changing fast enough and some are just assuming that this would be a one-time event that will not be repeated in the future (even if we are still not out of the current event!).

The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking. During those year a high inflation and low growth environment created a revolution among academics (moving away from the simple Phillips Curve) and policy makers (switching to anti-inflationary and independent central banks). How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Thursday, October 15, 2015

Ken Rogoff in the Financial Times argues that the world economy is suffering from a debt hangover rather than deficient demand. The argument and the evidence are partly there: financial crises tend to be more persistent. However, there is still an open question whether this is the fundamental reason why growth has been so anemic and whether other potential reasons (deficient demand, secular stagnation,…) matter as much or even more.

In the article, Rogoff dismisses calls for policies to stimulate demand as the wrong actions to deal with debt, the ultimate cause of the crisis. As he argues, given that government expenditures have kept expanding (he uses the number for France at 57% of GDP) it is hard to argue in favor of more spending.

But there is a perspective that is missing in that logic. The ratio of debt or government spending to GDP depends on GDP and GDP growth cannot be considered as exogenous. Assuming that the path of GDP is independent of the cyclical stance of the economy does not sound reasonable but, unfortunately, it is the way most economists think about a crisis. A crisis is seen as a temporary deviation of output but the trend
is assumed to be driven by something else (innovation, structural reforms,..). But that logic
runs contrary to evidence on the way investment and even R&D expenditures
behave during a crisis. If growth is interrupted during a crisis output
will never return to its trend. The level of GDP depends on its history, what
economists call hysteresis. In that world reducing the depth of a crisis or
shortening the recovery period has enormous benefits because it affects
long-term GDP.

[To be fair to economists, we are all aware of the persistent dynamics of GDP, but at the theoretical level we tend to explain it with models where the stochastic nature of the trend is responsible for the crisis itself rather than assuming that other factors caused the crisis and the trend reacted to them.]

In a recent paper Olivier Blanchard, Eugenio Cerutti
and Larry Summers show that persistence and long-term effects on GDP is a feature of any crisis, regardless
of the cause. Even crisis that were initiated by tight monetary policy leave
permanent effects on trend GDP. Their paper concludes that under this scenario, monetary and
fiscal policy need to be more aggressive given the permanent costs of
recessions.

Using the same logic, in an ongoing project with Larry Summers
we have explored the extent to which fiscal policy consolidations can be responsible
for the persistence and permanent effects on GDP during the Great Recession. Our empirical evidence very much supports this hypothesis: countries that implemented the largest fiscal consolidating have seen a large permanent decrease in GDP. [And this is true taking into account the possibility of reverse causality (i.e. governments that believed that the trend was
falling the most could have applied stronger contractionary policy).]

While we recognize that there is always uncertainty when estimating this type
of macroeconomic dynamics using one particular historical episode, the size of the effects that we find are large enough so that they
cannot be easily ignored as a valid hypothesis. In fact, using our estimates we calibrate the model of a recent paper by Larry Summers and Brad DeLong to show that fiscal contractions in
Europe were very likely self-defeating. In other words, the resulting (permanent) fall in GDP led to a
increase in debt to GDP ratios as opposed to a decline, which was the original objective of the fiscal consolidation.

The evidence from both of these paper strongly suggests that policy advice cannot ignore this possibility, that crises and monetary and fiscal actions can have permanent effects on GDP. Once we look at the world through this lens what might sound like obvious and solid policy advice can end up producing the opposite outcome of what was desired.

Thursday, October 8, 2015

Martin Wolf in today's Financial Times discusses the reasons for low interest rates and suggests some interesting scenarios for the years ahead. I agree with most of what he says but I have doubts about the role that he assigns to central banks.

Let me start with the arguments with which I agree 100%. The logic of the Bank for International Settlements that low interest rates are the outcome of central banks managing to keep interest rates artificially low for decades is "wildly impossible". And the main reasons are that we have no economic model (or evidence) that suggests that central banks are able to manipulate real interest rates for decades and we do not either have any model (or evidence) that supports the idea that a central bank policy of low interest rates will not generate substantial inflation.

As Martin Wolf argues, any explanation for low interest rates has to start with some version of the savings glut hypothesis. Economic, demographic and social changes have expanded the desire to save among a significant portion of the world economy and this has kept interest rates low. This is an explanation that is consistent with any economic model that has an intertemporal dimension built into it and there is plenty of evidence that supports it.

What is the role of monetary policy in this story? Martin Wolf believes that because of the increase in desire to save in the world, central banks

"in seeking to deliver the monetary conditions needed for equilibrium between savings and investment at high levels of activity, the central bank has to encourage credit growth"

Here is where I am not sure I follow Martin's argument. Why do central banks have to encourage credit growth? The fact that there is a savings glut that puts lower pressure on interest rates already means that somewhere in the world there will be an increase in credit/borrowing. There is no need for central banks to encourage credit. We can talk about whether central banks could have discouraged it, whether they had the tools and whether it was within their mandate, but there is no need to have central banks driving the process of credit growth to make the story consistent with what we have observed.

What makes the description of the dynamics of interest rates and financial flows that result from a savings glut difficult is the fact that we need to understand heterogeneity among economic agents (individuals, companies, governments). And this heterogeneity, combined with a regulatory framework that is limited, can drive dynamics that are unhealthy, excessive and lead to bubbles and financial crisis.

If there is a savings glut and interest rates are coming down this is a signal for someone to borrow more. Some of that borrowing will for sure be reflected in increase leverage because it will take the form of house purchases and creation of mortgages. Within some countries (e.g. China) we might observe that while the country as a whole saves, the private sector increases its internal debt exposure and leverage because of the exchange rate policies, government demand for foreign safe assets and capital controls that are part of their financial environment. There are plenty of stories like these that are triggered by a significant change in the economic scenario (lower interest rates) that might result in the financial imbalances that lead to crisis. The same way new technologies can create bubbles and financial instability (as in the 90s), the savings glut generated new and possibly excessive behavior as economic agents adapted (and not always well) to the new equilibrium.

Martin Wolf finishes with some thoughts on what come next. This is a difficult exercise as it requires a good understanding of economic trends across all regions in the world. There are some short-term forces that are playing against the savings glut hypothesis: oil producers countries are quickly reducing their saving, in some cases turning them into borrowers. But this is more than compensated by the Euro area that has become a large saver after the borrowers (Greece, Spain,...) have brought their current account deficits to zero while the savers (Germany, Netherlands) have not changed their behavior. So interest rates are likely to stay low and the saving surplus of some countries will have to be absorbed somewhere else (although it is not clear that the surpluses will be larger than in the past). Yes, this means a "credit boom" somewhere else but this should not always be a recipe for imbalances.

What the world is missing is investment demand. The real tragedy is that investment in physical capital has been weak at the time when financial conditions have been so favorable. Why is that? Jason Furman (and early the IMF) argues that the best explanation is that this the outcome of a a low growth environment that does not create the necessary demand to foster investment. And this starts sounding like a story of confidence and possibly self-fulfilling crises and multiple equibria. But that is another difficult topic in economics so we will leave that for a future post.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).